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The Fed's Taper Trap

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

There are many words in the English language that are seldom used, such as "ailurophile" and "Diaphanous." And "taper."

In fact, the only time I ever remember consistently hearing the word taper was in my youthful days when boys dared each other to use many annoying (and useless) pickup lines such as "I'm giving up sex. Will you help me taper off?"

On a more sobering note, any addict knows it is near impossible to actually taper off activities that feel good in the short run even if they are harmful in the long run.

The Point of QE

Since the onset of the financial crisis, the Fed has been pursuing a hyper-aggressive monetary policy strategy, first driving short-term interest rates to zero and then buying bonds to manipulate longer term rates down as well. Bond buying,described in a more technocrat fashion, is simply Quantitative Easing (QE).

One could also interpret such activity as money printing, though it is not exactly the same thing. (Only the Treasury can "print money" by running a deficit. The Fed must debit and credit bank accounts when making transactions).

The theory behind QE is to reduce the supply of Treasury and mortgage bonds outstanding, driving interest rates on those bonds down and encouraging borrowing and lending. The excuse for using such an extreme tool originally was to help avoid deflation. In fact, when the first two QEs were announced, inflationary statistics were dropping considerably - and they reversed when QE began.

But QE3 began without any increased threat of deflation. From that point on, the markets rightly interpreted QE as a stock market support program

Source:
Bloomberg, SVB Asset Management

The Market Always Wins

Fast forward to 2013 and we begin to see signs of a stronger economy: housing growth, consistent job gains, continuing corporate profits, etc. Bernanke saw the probability of a consistent upturn in the economy and wanted to prepare a reversalof Fed policy, before too much stimulus created high inflation.

At his June 19 press conference he signaled that a tapering of Fed purchases could begin if the economy continued to show signs of strength. And the markets went a bit nutso.

Many believe the markets missed Bernanke's message. But that's not the case.

The markets correctly interpreted Ben's salvo and immediately began discounting a shift in Fed action, proving the Fed may control the direction of policy implementation but the market controls the speed of that implementation.

In the following week, stunned Fed officials hit the speaking circuit trying to contain the damage.

The worst damage occurred exactly where the Fed had been aiming its stimulus: mortgage rates. The market-set Fannie Mae commitment rate for 30-year mortgages leaped over ½ percent from 3.54 percent on June 19th to nearly 4.12 percentjust five days later.

If anyone needs proof the free market is stronger than the government, this was it.

At the end of the day, the Fed tries to manipulate the market into doing its bidding. But in this instance, Bernanke read the tea leaves of recovery much sooner than the market. If the market believed recent positive economic data was a new andpositive trend - as the Fed did - then it wouldn't mind the Fed pulling back. Stronger activity in the future would more than offset some measly purchases by the Fed.

Or Is Bernanke Scared of Something Else?

A more frightening, but perhaps more likely, interpretation of recent events could be resulting from a failure of QE to bring about economic growth. It has been 11 months since the consistent $85 billion monthly purchases began and while we've seen some uptick in the economy, we haven't seen near enough to warrant any inflation fears.

Further evidence is the reduction in FOMC member estimates for economic performance in the near-term including a downgrading of GDP by 0.2 percent and steep drop in inflation expectations of 0.5 percent.

So, the Fed lowered its forecast for economic activity at exactly the same time it sent the taper message.

Could it be the world's most powerful central bank, while entering into an economic manipulation of the scale and description never before seen has now become so concerned about unintended consequences of its actions that it feels the need to back off?

If so, let's hope Fed members have the guts to go through with the pull-back even if near term volatility continues to ratchet up. Since market valuations remain somewhat attractive (for example, a 16 P/E is not at all that high compared to the lastcouple decades) we could see the markets come out of a QE exit virtually unchanged though perhaps somewhat disheveled by the volatility experienced as they interpret Ben's next move.

Unfortunately, Bernanke himself backed off the taper message in this week's Congressional testimony.

Maybe he believes QE is actually helping the economy afterall. And so continues the worst of both worlds: monetary policy that does not help the economy in the short run combined with increasing and dangerous unknowns to take effect once areversal ensues.

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

There are many words in the English language that are seldom used, such as "ailurophile" and "Diaphanous." And "taper."

In fact, the only time I ever remember consistently hearing the word taper was in my youthful days when boys dared each other to use many annoying (and useless) pickup lines such as "I'm giving up sex. Will you help me taper off?"

On a more sobering note, any addict knows it is near impossible to actually taper off activities that feel good in the short run even if they are harmful in the long run.

The Point of QE Since the onset of the financial crisis, the Fed has been pursuing a hyper-aggressive monetary policy strategy, first driving short-term interest rates to zero and then buying bonds to manipulate longer term rates down as well. Bond buying,described in a more technocrat fashion, is simply Quantitative Easing (QE).

One could also interpret such activity as money printing, though it is not exactly the same thing. (Only the Treasury can "print money" by running a deficit. The Fed must debit and credit bank accounts when making transactions).

The theory behind QE is to reduce the supply of Treasury and mortgage bonds outstanding, driving interest rates on those bonds down and encouraging borrowing and lending. The excuse for using such an extreme tool originally was to help avoid deflation. In fact, when the first two QEs were announced, inflationary statistics were dropping considerably - and they reversed when QE began.

But QE3 began without any increased threat of deflation. From that point on, the markets rightly interpreted QE as a stock market support program

Source:Bloomberg, SVB Asset Management

The Market Always Wins Fast forward to 2013 and we begin to see signs of a stronger economy: housing growth, consistent job gains, continuing corporate profits, etc. Bernanke saw the probability of a consistent upturn in the economy and wanted to prepare...Read More

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